CAPITAL EXPENDITURES: not having them is one of the secrets to getting rich

CAPITAL EXPENDITURES: NOT HAVING THEM IS ONE OF THE SECRETS TO GETTING RICH

Cash Flow Statement
($ in millions)
-> Capital Expenditures	($1,648)
Other Investing Cash Flow Items	(5,071)
Total Cash from Investing Activities	($6,719)

Capital expenditures are outlays of cash or the equivalent in assets that are more permanent in nature---held longer than a year---such as property, plant, and equipment. They also include expenditures for such intangibles as patents. Basically they are assets that are expensed over a period of time greater than a year through depreciation or amortization. Capital expenditures are recorded on the cash flow statement under investment operations.

Buying a new truck for your company is a capital expenditure, the value of the truck will be expensed through depreciation over its life---let's say six years. But the gasoline used in the truck is a current expense, with the full price deducted from income during the current year.

When it comes to making capital expenditures, not all companies are created equal. Many companies must make huge capital expenditures just to stay in business. If capital expenditures remain high over a number of years, they can start to have deep impact on earnings. Warren has said that this is the reason that he never invested in telephone companies---the tremendous capital outlays in building out communication networks greatly hamper their long-term economics.

As a rule, a company with a durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage. Let's look at a couple of examples.

Coca-Cola, a long-time Warren favorite, over the last ten years earned a total $20.21 per share while only using $4.01 per share, or 19% of its total earnings, for capital expenditures for the same time period. Moody's, a company Warren has identified as having a durable competitive advantage, earned $14.24 a share over the last ten years while using a minuscule $0.84 a share, or 5% of its total earnings, for capital expenditures.

Compare Coke and Moody's with GM, which over the last ten years earned a total $31.64 a share after subtracting losses, while burning through a whopping $140.42 a share in capital expenditures. Or tire-maker Goodyear, which over the last ten years earned a total of $3.67 a share after subtracting losses and had total capital expenditures of $34.88 a share.

If GM used 444% more for capital expenditures than it earned, and Goodyear used 950%, where did all that extra money come from? It came from bank loans and from selling tons of new debt to the public. Such actions add more debt to these companies' balance sheets, which increases the amount of money they spend on interest payments, which is never a good thing.

Both Coke and Moody's, however, have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time either reducing long-term debt or keeping it low. Both actions are big positives to Warren, and both helped him identify Coca-Cola and Moody's as businesses with a durable competitive advantage working in their favor.

When we look at capital expenditures in relation to net earnings we simply add up a company's total capital expenditures for a ten-year period and compare the figure with the company's total net earnings for the same ten-year period. The reason we look at a ten-year period is that it gives us a really good long-term perspective as to what is going on with the business.

Historically, durable competitive advantage companies used a far smaller percentage of their net income for capital expenditures. For instance, Wrigley annually uses approximately 49% of its net earnings for capital expenditures. Altria uses approximately 20%; Procter & Gamble, 28%; PepsiCo, 36%; American Express, 23%; Coca-Cola, 19%; and Moody's, 5%.

Warren has discovered that if a company is historically using 50% or less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage. If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favor.

And having a durable competitive advantage working in our favor is what it is all about.

The Problems with Leverage and the tricks it can play on you

THE PROBLEM WITH LEVERAGE AND THE TRICKS IT CAN PLAY ON YOU

Leverage is the use of debt to increase the earnings of the company. The company borrows $100 million at 7% and puts that money to work, where it earns 12%. This means that it is earning 5% in excess of its capital costs. The result is that $5 million is brought to the bottom line, which increases earnings and return on equity.

The problem with leverage is that it can make the company appear to have some kind of competitive advantage, when it in fact is just using large amounts of debt. Wall Street investment banks are notorious for the use of very large amounts of leverage to generate earnings. In their case they borrow $100 billion at, let us say, 6% and then loan it out at 7%, which means that they are earning 1% on the $100 billion, which equates to $1 billion. If that $1 billion shows up year after year, it creates the appearance of some kind of durable competitive advantage, even if there isn't one.

The problem is that while it appears that the investment bank has consistency in its income stream, the actual source that is sending it the interest payments may not be able to maintain the payments. This happened in the recent subprime-lending crisis that cost the banks hundreds of billions of dollars. They borrowed billions at, say, 6% and loaned it out at 8% to subprime homebuyers, which made them a ton of money. But when the economy started to slip, the subprime home-buyers started to default on their mortgages, which meant they stopped making interest payments. These subprime borrowers did not have a durable source of income, which ultimately meant that the investment banks didn't either.

In assessing the quality and durability of a company's competitive advantage, Warren has learned to avoid businesses that use a lot of leverage to help them generate earnings. In the short run they appear to be the goose that lays the golden eggs, but at the end of the day, they are not.

Total Liabilities and the Debt to Shareholders' Equity ratio

TOTAL LIABILITIES AND THE DEBT TO SHAREHOLDERS' EQUITY RATIO

Balance Sheet/             Debt to Shareholders' Equity Ratio
($ in millions)
Total Current Liabilities	$13,225
Long-Term Debt	3,277
Deferred Income Tax	1,890
Minority Interest	0
Other Liabilities	3,133
> Total Liabilities	$21,525

Total liabilities is the sum of all the liabilities of the company. It is an important number that can be used to give us the debt to shareholders' equity ratio, which, with slight modification, can be used to help us identify whether or not a business has a durable competitive advantage.

The debt to shareholders' equity ratio has historically been used to help us identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings).       

-  The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders' equity and a lower level of total liabilities. 

-  The company without a competitive advantage will be using debt to finance its operations and, therefore, should show just the opposite, a lower level of shareholders' equity and a higher level of total liabilities.

The equation is: Debt to Shareholders' Equity Ratio = Total Liabilities / Shareholders' Equity.

The problem with using the debt to equity ratio as an identifier is that the economics of companies with a durable competitive advantage are so great that they don't need a large amount of equity/retained earnings on their balance sheets to get the job done; in some cases they don't need any. Because of their great earning power they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base. That in turn increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a mediocre business---one without a durable competitive advantage.

Moody's, a Warren favorite, is an excellent example of this phenomenon. It has such great economics working in its favor that it doesn't need to maintain any shareholders' equity. It actually spent all of its shareholders' equity on buying back its shares. It literally has negative shareholders' equity. This means that its debt to shareholders' equity ratio looks more like that of GM---a company without a durable competitive advantage and a negative net worth---than, say, that of Coca-Cola, a company with a durable competitive advantage.

However, if we add back into Moody's shareholders' equity the value of all the treasury stock that Moody has acquired through stock buybacks, then Moody's debt to equity ratio drops down to .63, in line with Coke's treasury share-adjusted ratio of .51. GM still has a negative net worth, even with the addition of the value of its treasury shares, which are nonexistent because GM doesn't have the money to buy back its shares.

It is easy to see the contrast between companies with a durable competitive advantage and those without it when we look at the treasury share-adjusted debt to shareholders' equity ratio. Durable competitive advantage holder Procter & Gamble has an adjusted ratio of .71; Wrigley, meanwhile, has a ratio of .68---which means that for every dollar of shareholders' equity Wrigley has, it also has 68 cents in debt. Contrast P&G and Wrigley with Goodyear Tire, which has an adjusted ratio of 4.35, or Ford, which has an adjusted ratio of 38.0. This means that for every dollar of shareholders' equity that Ford has, it also has $38 in debt---which equates to $7.2 billion in shareholders' equity and $275 billion in debt.

With financial institutions like banks, the ratios, on average, tend to be much higher than those of their manufacturing cousins. Banks borrow tremendous amounts of money and then loan it all back out, making money on the spread between what they paid for the money and what they can loan it out for. This leads to an enormous amount of liabilities, which are offset by a tremendous amount of assets. On average, the big American money center banks have $10 in liabilities for every dollar of shareholders' equity they keep on their books. This is what Warren means when he says that banks are highly leveraged operations. There are exceptions though and one of them is M&T Bank, a longtime Warren favorite. M&T has a ratio of 7.7, which is reflective of its management's more conservative lending practices.

The simple rule here is that, unless we are looking at a financial institution, any time we see an adjusted debt to shareholders' equity ratio below .80 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for.

And finding what one is looking for is always a good thing, especially if one is looking to get rich.

LONG-TERM DEBT: Something that great companies don't have a lot of

LONG-TERM DEBT: SOMETHING THAT GREAT COMPANIES

DON'T HAVE A LOT OF

Balance Sheet/Liabilities
($ in millions)
Total Current Liabilities	$13,225
->Long-Term Debt	3,277
Deferred Income Tax	1,890
Minority Interest	0
Other Liabilities	3,133
Total Liabilities	$21,525

Long-term debt means debt that matures any time out past a year. On the balance sheet it comes under the heading of long-term liabilities. If the debt comes due within the year, it is short-term debt and is placed with the company's current liabilities. In Warren's search for the excellent business with a long-term competitive advantage, the amount of long-term debt a company carries on its books tells him a lot about the economic nature of the business.

Warren has learned that companies that have a durable competitive advantage often carry little or no long-term debt on their balance sheets. This is because these companies are so profitable that they are self-financing when they need to expand the business or make acquisitions, so there is never a need to borrow large sums of money.

One of the ways to help us identify the exceptional business, then, is to check how much long-term debt it is carrying on its balance sheet. We are not just interested in the current year; we want to look at the long-term debt load that the company has been carrying for the last ten years. If there have been ten years of operations with little or no long-term debt on the company's balance sheet it is a good bet that the company has some kind of strong competitive advantage working in its favor.

Warren's historic purchases indicate that on any given year the company should have sufficient yearly net earnings to pay off all of its long-term debt within a three-or four-year earnings period. Long-term competitive advantage holders Coca-Cola and Moody's could pay off all their long-term debt in a single year; and Wrigley and The Washington Post companies can do it in two.

But companies like GM or Ford, both in the highly competitive auto industry, could spend every dime of net profit they have earned in the last ten years and still not pay off the massive amount of long-term debt they carry on their balance sheets.

The bottom line here is that companies that have enough earning power to pay off their long-term debt in under three or four years are good candidates in our search for the excellent business with a long-term competitive advantage.

But please note: Because these companies are so profitable and carrying little or no debt, they are often the targets of leveraged buyouts. This is where the buyer borrows huge amounts of money against the cash flow of the company to finance the purchase. After the leveraged buyout the business is then saddled with large amounts of debt. This was the case with the RJR/Nabisco buyout in the late 1980s.

If all else indicates that the business in question is a company with a durable competitive advantage, but it has a ton of debt on its balance sheet, a leveraged buyout may have created the debt. In cases like these the company's bonds are often the better bet, in that the company's earning power will be focused on paying off the debt and not growing the company.

The rule here is simple: Little or No Long-Term Debt Often Means a Good Long-Term Bet.

Debt test of Warren Buffett

3 Quick Tests for a Business with a long-term Durable Competitive Advantage:

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

3. Debt Test

"One of the things you will find---which is interesting and people don't think of it enough---with most businesses and with most individuals, is life tends to snap you at your weakest link. The two biggest weak links in my  experience: I've seen more people fail because of liquor and leverage---leverage being borrowed money."

                                      Warren Buffett

   

     INTEREST EXPENSE: WHAT WARREN DOESN'T WANT

Income Statement
($ in millions)
Revenue	$10,000
Cost of Goods Sold	3,000
->Gross Profit	7,000
Operating Expenses
Selling, General & Admin.	2,100
Research & Development	1,000
Depreciation	700
Operating Profit	3,200
->Interest Expense	$200

Interest Expense is the entry for the interest paid out, during the quarter or year, on the debt the company carries on its balance sheet as a liability. While it is possible for a company to be earning more in interest than it is paying out, as with a bank, the vast majority of manufacturing and retail  businesses pay out far more in interest than they earn.

This is called a financial cost, not an operating cost, and it is isolated out on its own, because it is not tied to any production or sales process. Instead, interest is reflective of the total debt that the company is carrying on its books. The more debt the company has, the more interest it has to pay.

Companies with high interest payments relative to operating income tend to be one of two types: 

• a company that is in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or 
• a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

What Warren has figured out is that companies with a durable competitive advantage often carry little or no interest expense. Long-term competitive advantage holder Procter & Gamble has to pay a mere 8 % of its operating income out in interest costs; the Wrigley Co. has to pay an average 7%; contrast those two companies with Goodyear, which is in the highly competitive and capital-intensive tire business. Goodyear has to pay, on average, 49% of its operating income out in interest payments.

Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage. The consistently profitable Southwest Airlines pays just 9% of operating income in interest payments, while its in-and-out-of-bankruptcy competitor United Airlines pays 61% of its operating income out in interest payments. Southwest's other troubled competitor, American Airlines, pays a whopping 92% of its operating income out in interest payments.

As a rule, Warren's favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income. But be aware that the percentage of interest payments to operating income varies greatly from industry to industry. As an example: Wells Fargo, a bank in which Warren owns a 14% stake, pays out approximately 30% of its operating income in interest payments, which seems high compared with Coke's, but actually makes the bank, out of America's top five, the one with the lowest and most attractive ratio. Wells Fargo is also the only one with a AAA rating from Standard & Poor's.

The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in. Take the investment banking business, which on average makes interest payments in the neighborhood of 70% of its operating income. A careful eye would have picked up the fact that in 2006 Bear Stearns reported that it was paying out 70% of its operating income in interest payments, but that by the quarter that ended in November 2007, its percentage of interest payments to operating income had jumped to 230%. This means that it had to dip into its shareholders' equity to make up the difference. In a highly leveraged operation like Bear Stearns, that spelled disaster. By March of 2008 the once mighty Bear Stearns, whose shares had traded as high as $170 the year before, was being forced to merge with JP Morgan Chase & Co. for a mere $10 a share.

The rule here is real simple: In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage. In Warren's world, investing in the company with a durable competitive advantage is the only way to ensure that we are going to get rich over the long-term.

LONG-TERM INVESTMENTS: One of the secrets to Warren's success

LONG-TERM INVESTMENTS: ONE OF THE SECRETS TO WARREN'S SUCCESS

Balance Sheet/Assets
($ in millions)
Total Current Assets	$12,005
Property/Plant/Equipment	8,493
Goodwill, Net	4,246
Intangibles, Net	7,863
+ Long-Term Investments	7,777
Other Long-Term Assets	2,675
Total Assets	$43,059

This is an asset account on a company's balance sheet, where the value of long-term investments (longer than a year), such as stocks, bonds, and real estate is recorded. This account includes investments in the company's affiliates and subsidiaries. What is interesting about the long-term investment account is that this asset class is carried on the books at their cost or market price, whichever is lower. But it cannot be marked to a price above cost even if the investments have appreciated in value. This means that a company can have a very valuable asset that it is carrying on its books at a valuation considerably below its market price.

A company's long-term investments can tell us a lot about the investment mind-set of top management. Do they invest in other businesses that have durable competitive advantages, or do they invest in businesses that are in highly competitive markets? Sometimes we see the management of a wonderful business making huge investments in mediocre businesses for no other reason than they think big is better. Sometimes we see some enlightened manager of a mediocre business making investments in companies that have a durable competitive advantage. This is how Warren built his holding company Berkshire Hathaway into the empire that it is today. Berkshire was once-upon-a-time a mediocre business in the highly competitive textile industry. Warren bought a controlling interest, stopped paying the dividend so cash would accumulate, and then took the company's working capital and went and bought an insurance company. Then he took the assets of the insurance company and went on a forty-year shopping spree for companies with a durable competitive advantage.

Kiss even a frog of a business enough times with a durable competitive advantage and it will turn into a prince of a business.

Or, as in Warren's case, $60 billion, which is what his stock in Berkshire is now worth.

                              -------------------------

Return on Shareholders' Equity

SHAREHOLDERS' EQUITY/BOOK VALUE

Balance Sheet/Shareholders' Equity
($ in millions)
Total Liabilities	$21,525
Preferred Stock	0
Common Stock	880
Additional Paid in Capital	7,378
Retained Earnings	36,235
Treasury Stock--Common	-23,375
Other Equity	626
Total Shareholders' Equity	21,744
Total Liabilities + Shareholders' Equity	$43,269

When you subtract all your liabilities from all your assets you get your net worth. If you take a company's total assets and subtract its total liabilities you get the net worth of the company, which is also known as the shareholders' equity or book value of the business. This is the amount of money that the company's owners/shareholders have initially put in and have left in the business to keep it running. Shareholders' Equity is accounted for under the headings of Capital Stock, which includes Preferred and Common Stock; Paid in Capital, and Retained Earnings. Add together Total Liabilities and Total Shareholders' Equity and you get a sum that should equal Total Assets, which is why it is called a balance sheet---both sides balance.

Why Shareholders' Equity is an important number to us is that it allows us to calculate the return on shareholders' equity, which is one of the ways we determine whether or not the company in question has a long-term competitive advantage working in its favor.

Let's check it out.

RETURN ON SHAREHOLDERS' EQUITY: PART ONE

Balance Sheet/Shareholders' Equity
($ in millions)
Preferred Stock	0
Common Stock	880
Additional Paid in Capital	7,378
Retained Earnings	36,235
Treasury Stock--Common	-23,375
Other Equity	626
Total Shareholders' Equity	21,744

Shareholders' equity is equal to the company's total assets minus its total liabilities. That happens to equal the total sums of preferred and common stock, plus paid in capital, plus retained earnings, less treasury stock.

Shareholders' equity has three sources. 

• One is the capital that was originally raised selling preferred and common stockto the public. 
• The second is any later sales of preferred and common stock to the public after the company is up and running. 
• The third, and most important to us, is the accumulation of retained earnings.

Since all equity belongs to the company, and since the company belongs to the common shareholders, the equity really belongs to the common shareholders, which is why it is called shareholders' equity.

Now if we are shareholders in a company, we would be very interested in how good a job management does at allocating our money, so we can earn even more. If they are bad at it we won't be very happy and might even sell our shares and put our money elsewhere. But if they are really good at it we might even buy more of the company, along with everyone else who is impressed with management's ability to profitably put shareholders' equity to good use. To this end, financial analysts developed the return on shareholders' equity equation to test management's efficiency in allocating the shareholders' money. This is an equation that Warren puts great stock in, in his search for the company with a durable competitive advantage, and it is the topic of our next chapter.

RETURN ON SHAREHOLDERS' EQUITY: PART Two

Calculation: Net Earnings divided by Shareholders' Equity equals Return on Shareholders' Equity.

What Warren discovered is that companies that benefit from a durable or long-term competitive advantage show higher-than-average returns on shareholders' equity. Warren's favorite, Coca-Cola, shows a return on shareholders' equity of 30%; Wrigley comes in at 24%; Hershey's earns a delicious 33%; and Pepsi measures in at 34%.

Shift over to a highly competitive business like the airlines, where no one company has a sustainable competitive advantage, and return on equity sinks dramatically. United Airlines, in a year that it makes money, comes in at 15 %, and American Airlines earns 4%. Delta Air Lines and Northwest don't earn anything because they don't earn any money.

High returns on equity mean that the company is making good use of the earnings that it is retaining. As time goes by, these high returns on equity will add up and increase the underlying value of the business, which, over time, will eventually be recognized by the stock market through an increasing price for the company's stock.

Please note: Some companies are so profitable that they don't need to retain any earnings, so they pay them all out to the shareholders. In these cases we will sometimes see a negative number for shareholders' equity. The danger here is that insolvent companies will also show a negative number for shareholders' equity. If the company shows a long history of strong net earnings, but shows a negative shareholders' equity, it is probably a company with a durable competitive advantage. If the company shows both negative shareholders' equity and a history of negative net earnings, we are probably dealing with a mediocre business that is getting beaten up by the competition.

So here is the rule: High returns on shareholders' equity means "come play." Low returns on shareholders' equity mean "stay away."

Got it? Okay, let's move on.